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A new metric attempts to provide the ultimate context for technology investments.
Russ Banham, CFO IT
June 22, 2005
When Arinc Inc. makes decisions about technology projects going forward, it begins by looking back. The company, which provides systems-engineering solutions to the airline industry, has developed and started using a new metric: ROIE, or return on infrastructure employed. ROIE is a retrospective comparison of net earnings with yearly IT operating expenses — the networks, systems, and applications that underpin the business — expressed as a ratio, with a higher number being better than a lower one.
"ROIE helps me examine IT expenses in the context of our overall management infrastructure to see if IT has lived up to its promise," explains Arinc CFO Richard Jones. If IT delivers on that promise, then Jones is more likely to bankroll future technology projects that have a strong business case. "This is a much more effective metric than simply ascribing an ROI to each IT project and then justifying the individual rate of return," he asserts. "In my experience, when you try to justify ROI, you end up rationalizing a whole bunch of spending without being able to point to a specific result. We have found that an aggregate metric like ROIE is a far more useful indicator of overall IT effectiveness."
Is ROIE this year's TCO (total cost of ownership), EVA (economic value added), CBA (cost-benefit analysis), NPV (net present value), or what have you? Without question, this new twist on an old theme underscores the frustrations of finance executives who still struggle to link costly technology investments to tangible results. "If IT costs are going up and are not scaling with our business growth, something's out of whack," says Jones. "I wanted some way to continually question our processes and our infrastructure architecture."
Technology research firms, consultancies, and vendors have built a cottage industry on helping companies quantify the hard-dollar savings and softer productivity benefits of IT projects — and each adviser has its own unique series of measures to justify IT expenses. Gartner appends a long list of "risk-adjusted" metrics to its ROI calculation; while Forrester Research assesses the TEI (total economic impact), including the future operational benefits after the technology is implemented; and Nucleus Research stresses "case-based" analysis and research (see "More Twists on ROI").
Why tinker with something as solid and simple as good old ROI (net cash flow divided by initial investment)? Because ROI is anything but solid or simple. "It's as elusive as the Holy Grail," says Chip Gliedman, a vice president at Forrester. "There's no GAAP-accepted definition of ROI, no ROI tool that will tell them exactly what to do, no exact ROI model. As [Benjamin] Disraeli said, it's nothing but 'lies, damn lies, and statistics.'"
The 19th-century British prime minister was surely discussing another subject on the floor of Parliament, but most CFOs would agree that statistics are quite flexible, for good or ill. "ROI is an in-exact science simply because you're calculating the future impact of an infrastructure decision, and the future is impossible to predict accurately," says Jack Heine, a vice president and research director at Gartner. "You can make assumptions on economic cycles and business growth, which do affect the return, but you can't be sure they'll prove true." In fact, few companies actually evaluate ROI after the fact anyway. As Heine says, "If you have a project with a five-year ROI, chances are the IT people who got it going will be elsewhere when the time comes."
So why bother? Because "there is a history of IT projects not living up to their billing, coming in late, and costing more than they were supposed to," says Randy Perry, vice president of networking industry strategy at IDC. "Also, there are few ways other than ROI to measure the cost of a project versus the efficiency it is expected to offer."
"The issue isn't ROI as such, but defining metrics that are useful and meaningful," observes Michael Smith, a Gartner vice president in applied research. "Everyone wants a tidy, safe, and comfortable ROI measure. But it's the metrics within the metrics that really tell the tale."
Hence Arinc's decision to develop ROIE and consider it along with traditional ROI calculations for specific projects. Rather than simply manage IT project by project, the $700 million company takes the broader approach of comparing yearly technology operating expenses with net earnings. If that first number rises out of proportion to the second, IT may be consuming more dollars than justified by Arinc's business growth. "ROIE is really geared to the net effect of a collective set of projects, to see if they are tied to our business objectives," says Michael McShea, senior director of global project management for Arinc's network business.
"Like all companies, we want our cost growth to be lower than our revenue growth," explains McShea. Unless that's true, he continues, "you're not improving the performance of the IT organization from a financial standpoint. In that case, the CIO is potentially not doing his or her job to increase the value that IT is bringing to the firm. You should only undertake projects that collectively improve your ROIE."
Although ROIE is a retrospective calculation, it helps in deciding if the costs and benefits of a project make financial sense. For example, say the CFO is presented with a business case for a $10 million CRM system. By examining the company's ROIE before and after the project was added, the finance chief gains a better understanding of the aggregate effect on IT performance in the context of earnings growth. If the ROIE is less than stellar, it forces the conversation to a solution that offers the functionality of the CRM system at lower introductory cost. "If revenue is growing and EBIT [earnings before interest and taxes] is steady, then the increasing costs of IT may be disproportionate to what the business can accept, and the company may want to look for other ways for the project to fly, such as a hosted or outsourced solution," says McShea. "It forces IT managers to minimize fixed costs."
At Arinc, as it turned out, the converse was true: the company's analysis of its ROIE gave it the assurance it needed to make significant investments in technology, even as its main market — aviation — was suffering. "The airline industry is beset by bankruptcies; its problems obviously put pressure on our company to lower prices," says McShea. "Nevertheless, our ROIE indicated we could risk investments in a new billing system and network that we would have thought impossible in the kind of market we're in."
"We've spent some money and are now more productive than we used to be," adds Jones. "But we wouldn't have spent the money if we felt that IT was not in sync with our business objectives. The ROIE validated the investments made [by IT]."
Arinc's ROIE indicates a 10 percent improvement in IT's return on dollars spent in 2004, compared with the previous year. "At the same time, IT spent 15 percent more," says Jones. "The moral is that returns are not always about cost reduction."
More Twists on ROI
Whereas ROIE is retrospective, TEI is prospective, and it, too, can provide another piece of the technology decision puzzle. Forrester Research offers to analyze the "total economic impact" of a potential project in terms of other projects that may spring from it, integrate with it, or otherwise benefit from it.
"If a company is planning to implement a new application-server infrastructure to support a specific project, it would make sense to ponder the possibility of similar projects that come down the road that have significant value," says Forrester vice president Andrew Bartels. Quantifying those other projects, he continues, "allows you to assert a probability of 20 or 50 percent lower up-front costs" on the project that's already under way. In effect, he maintains, "you're buying an option — and the option can expire on exercise and out of the money — but it's there as a hedge to give you flexibility."
Bartels's colleague Chip Gliedman elaborates: "With a financial option, one purchases the right to acquire a stock at a price negotiated today; in the same regard, investing in additional infrastructure above today's needs can enable the deployment of future applications. These applications may not yet be identified or budgeted, but the right to take these actions in the future still has value to the organization that typically is not reflected in traditional ROI efforts."
Stanford University has used TEI in its calculations for every IT project undertaken since September 2003. "We just used it as part of a project we implemented for doing patches on our Windows machines," says Bill Clebsch, executive director for the IT systems and services department at Stanford. "We realized a number of future options that were a byproduct of the security software, such as the ability of department administrators to 'push' out new desktop images or software when their department needed it, rather than have them come to IT to 'pull' it. The value of that future option was almost as large as the security gain." In addition to a positive ROI and expected savings of six figures over the next five years, Clebsch says Stanford could potentially save an equal amount via the future option.
Gartner offers a risk-adjusted take on returns from technology that looks at "the flip side," explains research director Jack Heine: the prospect of "the IT project not achieving the ROI." To do that, Gartner has developed a methodology that uses a business-performance framework containing nine aggregate and 54 prime metrics affected by the project, calculating such factors as the effectiveness of marketing, sales, and product development, as well as suppliers, human resources, IT, and the finance department. Within each category, Gartner drills down to show potential benefits resulting from an IT-enabled business initiative: in evaluating customer responsiveness, for example, the consultancy quantifies on-time delivery statistics, order fill rate, service accuracy, and material quality, among other factors.
These metrics are like an "EKG on the enterprise," says Heine's colleague Michael Smith. They "focus the attention of both business and IT professionals on issues that generate future cash flows: things like demand management, supply-chain management, and support services." Armed with this data, he argues, a company can "capture the total effect of an investment in IT. You can now talk about the effect of a new CRM system on customer retention because you now have a metric that supports this discussion; you can describe the system in the context of improving the metric."
"What keeps CFOs up at night," says Smith, "is the angst associated with a $10 million IT project that offers many benefits, all of them intangible. We're trying to give as much substance as possible to the insubstantial." — R.B.